High frequency trading has a beneficial effect on markets, according to a paper published by the European Central Bank which calls into question moves towards greater industry regulation.
The use of computer algorithms for high frequency trading – where large volumes of transactions are made across different venues for small gains – has come under scrutiny from regulators following the Flash Crash of 2010 which sent the Dow Jones index falling 700 points in just a few minutes, as high frequency traders sold off masses of securities.
However, the report, written by three academics, contends that the presence of high frequency traders (HFT) can help reduce market volatility and create stability and price efficiency. The report, ‘High frequency trading and price discovery’, analyses data on 120 stocks traded on Nasdaq between 2008 and 2009, with 60 stocks listed on the New York Stock Exchange (NYSE) and 60 listed on Nasdaq.
“Our research suggests, within the confines of our methodological approach, that HFT provide a useful service to markets. They reduce the noise component of prices and acquire and trade on different types of information, making prices more efficient overall,” the authors state.
“Introducing measures to curb their activities without corresponding measures to that support price discovery and market efficiency improving activities could result in less efficient markets.”
The UK government indicated in its report released last year, ‘The Future of Computer Trading in Financial Markets’, that it would look to tighten rules on high frequency trading in order to limit swings in markets and improve management of market risks. High frequency trades currently make up around 30 percent of securities traded in the UK.
The ECB itself has attacked the high-speed trading practices in the past, with council member Ewald Nowotny claiming in 2012 that high-frequency trading cannot be properly regulated and should be banned.
“There are cases in which regulation achieves more with simple bans than with sophisticated regulations. One concrete example is high-frequency trading," Nowotny said at the time. "This can’t be regulated, this should be banned.”
According to financial services technology analyst at Ovum, Rik Turner, while high-speed trading strategies do have benefits, they still involve risk for markets and for trading firms.
“HFT adds liquidity by increasing buying and selling activity, but it could be argued that it distorts the market in that it places many more orders than it hopes to fill, and cancels them by the bucketload,” Turner said.
“There is also the question of whether it is unfair to other market participants in that they cannot hope to compete on a level playing field.”